Tied down: despite a recent overhaul, insurance company insolvency laws are still mired in redundancy and high costs.

After spending the past few years working to rewrite the insurance receivership model law, the National Association of Insurance Commissioners has adopted a new version.

Many inside and outside the industry believe this initiative has failed to address fundamental concerns with the effectiveness of the state-based receivership system. As some have observed, the present statutory structure for managing insolvencies is flawed with incentive conflicts, a perceived lack of control and oversight, as well as high costs. Some receiverships have been managed well. The lack of accountability and data, however, leaves a system that is obscured and in need of attention and reform.

Today's Environment

The structure and management of insolvent insurance and reinsurance companies in the United States differs dramatically from bankrupt companies in any other industry. As insurance is regulated by the states, and insurers are explicitly excluded as debtors under the Federal Bankruptcy Code, it is up to individual state insurance regulators to determine whether a carrier is operating in a way that is potentially harmful to policyholders, and to petition the court of jurisdiction for an order placing the carrier in some form of receivership.

State-based insurance regulation, including the oversight of insolvency proceedings, evolved in a time when most carriers were single-state writers of insurance with a particular focus on personal lines of insurance. The system worked effectively until a series of underwriters of primarily commercial insurance and reinsurance became insolvent in the mid and late 1980s. Companies such as Integrity, Mission, Transit, Midland, Pine Top and Southern American were anything but single-state writers of personal lines insurance. Most recently, Reliance in 2001 and Legion in 2002 have continued the trend of large commercial carrier failures.

Cost

The process of liquidating an insolvent insurer is governed by state statutes that impose obligations on the regulator as receiver. However, the perception of inadequate transparency, accountability, oversight and misplaced incentives exacerbate concerns about inefficiency and high costs. The construct of the statutes creates additional costs. Once a company enters liquidation, assuming the claim has guaranty-fund protection, the claim is typically transferred to a new adjuster and new counsel, thus imposing a second review of the claim.

Once the claim is resolved by the guaranty fund, it is returned to the state receiver, who then performs a third review to determine if the guaranty fund is entitled to a claim for its payments and whether there remain any additional claims beyond those covered by the guaranty fund. Liquidation by its very nature imposes additional claim reviews and costs beyond those that are typical in the industry. This is not a criticism of the guaranty funds or the receivers--it is simply a recognition that the statutes create additional costs which are ultimately borne by the residual assets of the insolvent carrier, effectively reducing assets available for distribution to creditors.

Reinsurance

The largest asset of an insolvent carrier is typically reinsurance. While guaranty funds maintain primary claim handling and payment obligations to the extent guaranty fund coverage exists, it is the receiver's statutory obligation to seek recovery of all assets and most importantly, reinsurance. The result is as many as 50 claim-paying organizations (guaranty funds in all 50 states) and a single receiver responsible for collecting the relevant information, processing that information and collecting the cash from reinsurers. The success of this endeavor is highly dependent on an efficient mechanism or system to support the transfer of data and documentation. Such an efficient and fully functioning system does not exist, which has created tremendous lags in collection activities, and jeopardizes collection efforts.

Financial Reporting

Statutory insurance accounting and the filing requirements promulgated by the NAIC create tremendous value for regulators, investors, risk managers and other purchasers of insurance by providing a standard financial reporting format and content. This information can be accessed through a variety of sources, including A.M. Best, and can be used to perform comprehensive and comparative financial analyses because it is reported in a standard format and subject to a common set of reporting rules and accounting principles.

Once a carrier enters receivership, statutory financial reporting ceases and is replaced by periodic financial reports submitted to the court of jurisdiction overseeing the liquidation. While some receivers make these reports available electronically, others do not. Adding to the challenge is the lack of any consistent format and accounting rules governing this reporting. As a result, it is virtually impossible to evaluate the relative success or failure of an insolvency proceeding beyond the final distribution percentage, which is not necessarily a fair or meaningful metric. It has been argued that the lack of credible and consistent financial reporting creates an environment which lacks basic accountability. How do receivers know if they are doing a good job or a bad job ff they have no way to measure their success vs. others similarly situated?

Creditor Involvement

A fundamental component of the federal bankruptcy system is the existence of various creditor committees to represent the interests of different classes of creditors.

The state-based receivership statutes make no provision for creditor committees, and therefore creditors have little ability to act in any sort of meaningful oversight role in a liquidation proceeding. That role is left to the receiver and the court of jurisdiction--typically a state court. One has to wonder how a trial judge, primarily focused on a docket loaded with civil matters, and typically with little training in insurance or insurance insolvency, can oversee such a complicated proceeding and deliver the kind of accountability provided by creditor committees in the federal bankruptcy system.

Government's Role

A continuing question is whether the states are best positioned to administer receiverships. Economists believe that the government should perform only those functions that cannot be performed efficiently or effectively by the private sector. An exploration into whether such an approach practiced in other parts of the world would improve efficiencies in the United States is needed.

The Alternative

New models of how to manage financially troubled carriers are emerging. In some cases, carriers are engaged in a commercial runoff under the close scrutiny of the insurance regulators. In other cases, carriers operate under an order of rehabilitation without triggering the guaranty fund system.

The benefits to these approaches include the continuance of financial reporting in accordance with NAIC standards, the avoidance of redundant claim reviews and the associated costs, the continuance of centralized claim functions, as well as the application of consistent claim evaluation guidelines and the equitable treatment of policyholders. As with any model, there also are drawbacks and opportunities for enhancement.

It's fortunate that no major insolvencies have occurred since Legion and Reliance. Why not then use this quiet period as an opportunity to address the many challenges facing the receivership and guaranty fund system?

Key Points

* The process of liquidating an insolvent insurer is governed by state statutes.

* Many inside and outside the industry say the NAIC's overhaul of receivership laws failed to address concerns with the effectiveness of the state-based receivership system.

* The construct of the receivership statutes creates additional costs and obscures financial transparency.

A Case for Uniformity: Insurance Is Not a Hamburger

One key question is whether having consistent insolvency procedures across states is an important goal. Does it really matter that the rules and regulations vary from state to state? In answering this question, consider the broader evolution of the American economy.

For example, a consumer can go to a McDonald's restaurant in Iowa and in Arkansas and expect, and typically receive, the same or substantially similar products. Obviously, this is a key element of McDonald's success. Of course, insurance is not a hamburger. But it certainly seems logical that the typical consumer would expect that an insurance policy purchased from Supersecure Insurance Co. in Texas and one purchased in Idaho would have similar protections in place should Supersecure become insolvent. Today that is not necessarily the case.

A persistent question is whether some type of federal solution is the answer. A consideration might be to bring insurers under the jurisdiction of the Federal Bankruptcy Code. Would this solve all of the challenges? Likely not, but it would provide the oversight of creditor committees and a trained and specialized judiciary.

Contributors Jerry Capell and Jim Schacht are managing directors in the Insurance & Claims Practice of Navigant Consulting. They can be reached at [e-mail] and [e-mail]